Are 409A Valuations a “Shell Game” and a “Dirty Little Secret”?

William D. Cohan, writing in the New York Times’ DealBook, characterizes the third-party valuations of private companies under Section 409A of the Internal Revenue Code as Silicon Valley’s “dirty little secret” and a “shell game.” Especially in the aftermath of the financial crisis, there has been plenty of populist rhetoric about practices in the business world, and much of that criticism has had basis in fact, but this take on 409A valuations seems awfully strained.

As described in Cohan’s article, Section 409A and the related rules require that companies obtain independent valuations in connection with their issuance of equity-based awards to employees, and failure to comply results in tax penalties. Cohan details the fact that various service providers charge significant fees to undertake these valuations, using words like “supposed” experts to make the whole enterprise seem like a racket, but the reality is that the rules do exist, and these valuations have to be done. If it was possible for just anyone to make up a valuation for a bargain-basement fee, heck, I would consider doing it as a side gig from my legal work. But the rules actually go into detail as to the required qualifications for firms providing these services. Cohan notes in the article that the SEC would not comment on these practices, but this is really more of an issue of tax law than securities law. What constrains companies and their hired valuation help from simply making up numbers out of thin air is the fact that their decisions are subject to later IRS scrutiny and sanctions.

John Jenkins of The Corporate Counsel, whose blog post led me to the Cohan article, takes issue with Cohan’s assertion that 409A valuations of common stock are often unjustifiably less than the valuations of the preferred stock in the same company purchased by institutional investors. Cohan does note in a parenthetical that common and preferred classes of stock have different rights that can justify a different valuation, but that distinction is the whole point, not an aside. A sale of a company at a particular price could result in preferred stockholders with a liquidation preference receiving significant proceeds and the common receiving not a cent. Accordingly, it’s perfectly appropriate for the valuations to differ significantly.

Finally, Cohan quotes an investor who criticizes the false precision of these valuations, “to the second decimal place.” Of course, any debate over whether the common shares of a private company are worth $5.44 per share rather than $5.45 would be an extremely dumb one, but the fact is that the 409A valuation process requires that a number be established. So, if you imagine a company that happens to have 2,757,353 common shares outstanding and no preferred, and it’s estimated that the value of the whole company is $15 million, then you end up with a per share value of $5.44. What’s wrong with that? Even if the gross total number in a valuation isn’t a round number, that is likely a result of the methodology used by the valuation company, not some weird effort to impress people with faux numerical genius.

Press Coverage

"Andrew Abramowitz, a lawyer in Manhattan who has worked with both buyers and sellers of private placements, said every investor should approach a private placement skeptically." -- Paul Sullivan (New York Times)

"If the goal [...] is to protect people from losing all of their money in an illiquid investment, the current standard fails on that count, too. Andrew Abramowitz, a lawyer in Manhattan who has worked with both buyers and sellers of private placements, said a better standard might be to limit how much of their net worth people can invest." -- Paul Sullivan (New York Times)